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The Sum is Greater than the Parts:

Doubling Shared Prosperity in Indonesia

Through Local and Global Integration

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Table of Contents

Page

Preface v

Abstract vi

Executive Summary vii

CHAPTER ONE 1

Indonesia's Development

Challenge:

Doubling Shared Prosperity by Accelerating Sustainable, Inclusive Growth Cukup Baik Tidak Cukup - Good Enough is Not Enough 1

How fast has Indonesia grown? 3

How competitive is Indonesia's growth? 12

How fairly has Indonesia grown? 16

Comparative Growth Performance 18

Study Context and Organization 24

CHAPTER TWO 27

Strategy for Accelerating Sustainable, Inclusive Growth:

Local and Global Economic Integration

The Binding Constraint in Accelerating Sustainable, Inclusive Growth 27

Local Economic Fragmentation 27

Global Economic Marginalization 31

Local and Global Economic Integration 33

CHAPTER THREE 39

Improving Hard and Soft Infrastructure:

Reducing the Costs of Logistics and Transactions

Indonesia's High Cost Economy 39

The Context of Logistics and Transactions Costs 41 Indonesia's Hard Infrastructure Deficit: Logistics Costs and Efficiency 44 Indonesia's Soft Infrastructure Deficit: Transaction Costs and Productivity 53

Lessons and Policy Prescriptions 73

iii

CHAPTER FOUR 76

Developing and Utilizing Human Resources:

Promoting Productive Employment and Livelihoods

Productive Work, Employment, Livelihoods, and Economic Growth 77 Boosting Productive Work in Indonesia 83 Raising Labor Productivity by Improving the Quality of Higher Education 93 Synergies in Broad-Based Initiatives 102

CHAPTER FIVE 104

Getting Things Done:

The Politics of

Doubling Shared Prosperity

Political Benefits of Inclusive Growth 105 The Horizontal Politics of Getting Things Done: Executive-Legislative Relations 107 The Vertical Politics of Getting Things Done: Intergovernmental Relations 115 Promoting Local Investment: The Mining Sector 118 Politics, Investment, and Effective Decentralization 121

CHAPTER SIX 125

Moving Forward:

Reactive, Proactive, and Transformative Policy Alternatives

Three Development Paths 125

Reactive: Policy by Exception 126

Proactive: Sporadic Reform 128

Transformative: Fundamental Metamorphosis 130

The Road Not Taken 131

Annexes

Annex 1:

Indonesia - Selected Indicators 134

Annex 2:

Labor, Capital and Total Factor Productivity in Indonesia 135

Annex 3:

What are Public Private Partnerships? 138 Annex 4: Where Has All the Garlic Gone? 141 Annex 5: State Capacity, Governance, and Credibility 144 Annex 6: "HE Drives Growth" - Empirical Issues 147

References 149

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Figures

Figure 1.1: Indonesia's YoY GDP Growth

With Focus on

Krismon 5

Figure 1.2: Indonesia and Regional Peers

GDP Growth Rates (CAGR, %) 6

Figure 1.3: Indonesia and Country Peers

GDP Growth Rates (CAGR, %) 6

Figure 1.4: Manufacturing Value-Added per Employee (USD) 14 Figure 1.5: Saving and Investment Rates among Regional Peers 18 Figure 3.1: Domestic Credit Provided by Banking Sector (% of GDP) 55 Figure 3.2: Broad Money (% of GDP) 55 Figure 3.3: CPI Inflation Rates (%) 56 Figure 3.4: Nominal Prime Interest Rate (%) 59 Figure 3.5: Nominal Exchange Rate Against USD 67 Figure 3.6: Share of Manufacturing Output (% by Region) 72

Figure 3.7: Share of Manufacturing Output

Zoom in on the AFC (% by Region) 72

Figure 4.1: Population 15 Years of Age and Over by Main Industry (% Pop) 79

Figure 4.2: Population 15

Years of Age and Over by Main Employment Status (% Pop) 79 Figure 4.3: Arable Land and Agricultural Output 88 Figure 4.4: Employment in Agriculture (% of total) vs. Agriculture Output (% GDP) 89 Figure 4.5: HDI Index Trend Over Time 93

Figure 4.6: HDI Index Regional Benchmark, 2012

94

Text Boxes

Box 1.1: Government of Indonesia's Development Plans 2 Box 1.2: Indonesia's Middle Class as a Driver of Economic Growth 8

Box 1.3

: "Stability" and "Balance" in the Indonesian Economy 11 Box 1.4: Total Factor Productivity in Indonesia 15 Box 1.5: Measures and Trends of Inequality in Indonesia 17 Box 2.1: Why Is There So little Support for MP3EI? 36 Box 3.1: Improvements in Personal Transport as a Negative Sum Game 43

Box 3.2: Corruption and Growth 57

Box 3.3: Indonesia's Banking System 60

Box 3.4: Dutch Disease 69

Box 3.5: Garlic, Salt, and Oranges - A Taste of Declining International Competitiveness 70

Box 4.1: Informal Work

78
Box 4.2: Labor Productivity and Long-Term Growth and Development 81 Box 4.3: Agricultural Workers and Output on Java and Ou ter Islands, 2007 -2011 87 Box 4.4: The Educational Effect of Economic Growth 96
Box 5.1: Sources of Violence in Indonesia 106 Box 5.2: Legislative Leadership Constellation in Indonesia's Emerging Democracy 108

Box 5.3

: Consensus in Indonesian Politics 111 Box 5.4: The Capacities of the DPR Secretariat General 114 Box 5.5: The Political Economy of Reform in Southeast Asia 122 v

PREFACE

In 2011, the Harvard Kennedy School Indonesia Program (HKSIP) published From Reformasi to Institutional

. This was our first effort to nation. Reformasi -

party democracy despite its geographic, ethnic, and religious diversity and the destabilizing turmoil that accompanied the end of

also economic recession experienced by most countries.

However, despite this impressive progress, we highlighted a number of problems as well that were preventing

Indonesia from achieving its full potential. These impediments all pointed to the need for fundamental institutional

transformation: continuation of patrimonial politics, perpetuation of an economic oligarchy, high barriers to entry in a wide

range of industries, a dysfunctional legal system, disempowered citizens, and insufficient investment in infrastructure, health, and

education. Thus, in comparison with its regional neighbors and global competitors, Indonesia was falling behind in many crucial

measures of economic and social well being.

The Sum is Greater than the Parts: Doubling Shared Prosperity in Indonesia Through Local and Global Integration

is a sequel to our first study. It further examines constraints to robust, sustainable, and equitable growth in Indonesia, and

ive of joining the ranks of upper middle-income countries by 2025.

In addressing these issues, we ask:

1) Is Indonesia growing fast enough to double real per capita income over the next decade?

2) ? Is it equitable?

The findings are discouraging. The growth rate is far below the level necessary to reach upper middle-income status by

2025, and this modest growth has been characterized by lack of job creation, declining competitiveness, and rising inequality.

This is primarily because Indonesia has neither reaped the full benefits of being a large country nor positioned itself well in the

global supply chain.

But our recommendations leave us cautiously optimistic. Although adhering to the current growth strategy does not

he constraints to achieving high levels of sustainable, inclusive growth can be addressed, even in landscape. The key to both local and global integration is the same: greater

investment in enabling hard infrastructure such as roads, ports, and power; improved soft infrastructure in the form of better

government and governance; and development of human resources through more effective education and training.

leaders take the proactive policy path outlined in this study, prospects for more rapid and higher quality growth over the next

decade are good; they are even better if a more transformative approach is adopted.

Like our first study, this report was written by an interdisciplinary team from the Ash Center for Democratic Governance and

Innovation at the Harvard Kennedy School, and it benefitted enormously from the insights and guidance of numerous Indonesian

colleagues. Its purpose is to contribute to a public ther

efforts to enhance the quality of public policy formulation, implementation, and evaluation in Indonesia by bringing Indonesian

students, faculty, and practitioners to Harvard, and engaging in collaborative research between Harvard and Indonesian scholars.

We look forward to continuing our joint efforts to improve the current lives and future prospects of all Indonesians.

Anthony J. Saich

Daewoo Professor of International Affairs

Director, Ash Center for Democratic Governance and Innovation

Harvard Kennedy School

Harvard University

Cambridge, Massachusetts, United States

vi

ABSTRACT

The GOI's primary development objective is to join the ranks of upper middle-income countries by 2025.

If Indonesia could double shared prosperity over the next decade, that is, generate an annual real GDP per

capita growth rate of 8.5 percent for the next ten years, it would be well on the path to achieving this

objective.

However,

at the present maximum per capita annual growth rate of 4.5 percent, not only will

Indonesia

fall well short of its target, but it will also continue to experience jobless growth, declining

competitiveness, and rising inequality. Clear indicators of current trends, in addition to the modest GDP

per capita growth rate, are the long-term decline in total factor productivity and more recent fall in

manufacturing value added per employee, as well as steadily rising measures of inequality such as the

Gini coefficient. The binding constraint to

accelerating sustainable, inclusive growth is that Indonesia

exploits neither the benefits of being a large country nor its international dynamic comparative advan

tage.

Indonesia is beset by local economic fragmentation and global economic marginalization. At present, the

sum is worth less than the parts - Indonesia does not have an integrated domestic economy. Instead, it is

a collection of disconnected local an d regional markets. The country has also undergone a significant disengagement from global production and distribution value chains. Its growth is dependent on commodities and old industries instead of high value-added products. Extending and integrating the domestic market, and linking it better to global value chains, will reduce economic distance and diminish barriers to trade and exchange. The key to addressing both domestic and international market problems is essentially the same, namely better hard infrastructure (ports, power, roads), soft infrastructure

(government and governance), and wet infrastructure (human resources). This will reduce the costs of

logistics and transactions, and promote productive employment and livelihoods. A requirement for effective implementation of new development policies is adroit management of both the horizontal

politics (executive-legislative relations) and vertical politics (intergovernmental relations) of getting

things done. Based on Indonesia's historical context and its current economic, political, and social

environment, the nation has a choice of three future development paths: reactive, proactive, and

transformative. Reactive, or policy by exception, best describes the GOI's current "muddling through"

modus operandi; proactive, or sporadic reform, refers to policies pursued in response to past major crises

such as widespread malnutrition and rural poverty in the 1960s and the collapse of oil prices in the 1980s;

and transformative, or fundamental metamorphosis, characterizes the policies over the past half-century

that have morphed the "Four Asian Tigers" (South Korea, Taiwan, Hong Kong, and Singapore) into high income nations. The reactive approach will produce the same performance as the last decade steady but unspectacular and largely jobless growth with declining competitiveness and growing inequality. The

proactive approach will stimulate rapid growth in Indonesia for at least a decade, and inequality will not

worsen - it might even decline. The transformative approach would, for the first time in Indonesia's history, move the economy onto a robust, sustainable, and equitable development trajectory. vii

EXECUTIVE SUMMARY

I. Indonesia's Development Challenge:

Doubling Shared Prosperity by Accelerating Sustainable, Inclusive Growth

Cukup Baik Tid

ak Cukup

Good Enough is Not Enough

When Indonesians are asked how well their economy is performing, they often say "cukup baik" ("good enough"). There is a widespread sense of complacency that Indonesia"s economic development policies must be generally sound, because although not spectacular, GDP growth has been steady over the fifteen years since Indonesia"s recovery from

Krismon (the East Asian

Financial Crisis), including strong performance throughout the recent Global Economic Crisis.

This confidence has been supported by

praise from international aid agencies, private consulting firms, and academics for Indonesia"s macroeconomic performance since Krismon, its status as a fast-growing MIST member, its potential as a new BRIC, and its imminent emergence as a "giant of Asia " They also project that Indonesia"s growth will continue, supported by its expanding middle class and continuing external demand for natural resources. However, even the GOI acknowledges that the current development trajectory will not achieve its own objectives. The GOI has been promoting double-digit growth in order to create an upper middle-income country by 2025, and although growth in Indonesia might indeed continue for some time, i f it remains on its present path, it will fall short in three fundamental dimensions: Job Creation: It will not be rapid enough to create sufficient employment opportunities for Indonesia"s quickly growing labor force. It will be characterized by jobless growth. Competitiveness: It will not be diversified, productive, or economically integrated enough to be sustainable. It will be characterized by declining competitiveness. Equity: It will not be inclusive enough to ensure shared prosperity from Indonesia"s growing national wealth. It will be characterized by rising inequality. Jobless growth, declining competitiveness, and rising inequality will not thrust Indonesia into the ranks of high -income countries, thus thwarting the government"s own policy objective. Instead, it is a recipe for rising unemployment and underemployment, increased counterproductive protection of local businesses, and growing political and social unrest. Rather than potentially propelling Indonesia on a virtuous cycle of rapid, sustained, and inclusive growth, it threatens to send the country into a downward spiral of economic stagnation and popular discontent.

How fast has Indonesia grown?

When compared to

other lower middle income countries, Indonesia"s growth over the last two decades has been relatively strong but not outstanding. From 1990-2000 and 2000-2010,

Indonesia"s annual growth averaged 4.2

percent and 5.3 percent, respectively. During the most recent decade, Indonesia"s growth was lower than both comparator groups and regional peers. viii Despite lower comparative growth, Indonesia has benefited from a combination of strong external demand for its natural resource exports and prudent internal macroeconomic management such as its conservative approach to budgeting, official reluctance to borrow, legislated upper bound on the debt/GDP ratio, and hyper-accumulation of foreign exchange reserves. This has produced the "macroeconomic stability" about which there is much favorable comment, characterized by budget balance, relatively low inflation, a declining debt to GDP ratio, and a stable nominal exchange rate.

In addition,

the financial system has been recapitalized and the large banks are extremely liquid, solvent, and profitable. The expansion of consumer credit has enabled the country's middle class to raise its living standards significantly over the last decade. One of the principal drivers of economic growth has been the rising incomes and expenditures of this "new consumer class," underpinned by the boom in natural resource exports and increased borrowing. Indonesia's political and administrative situation has stabilized as well. The challenges posed by democratization and decentralization are being met in ways that create opportunities for peaceful social change and economic development. Indonesia 's highly inter-connected and increasingly mobile citizens are gaining experience in the values of openness and freedom, and are now insisting on higher standards of transparency and accountability from their representatives. Nonetheless, recent performance has fallen far short of the GOI's economic targets. For example, the National Medium-Term Plan Development Plan (RPJMN 2004-2009) was formulated to be "pro -growth, pro-jobs, and pro-poor" but: real aggregate GDP increased at an average annual rate of only 5.5 percent (or 4.3 percent per capita); formal sector employment grew by only 2.8 million, in contrast to an increase in the aggregate labor force of 7.2 million; and measured against the national benchmark, poverty increased from 16.7 percent of the population in 2004 to a peak of 17.8 percent in 2007, and then declined to 14.2 percent in 2009. It is easy to find deficiencies and problems. Nonetheless, a reality check is a useful counter- weight to the widespread extravagant commentary about Indonesia's performance. The GOI's economic management has created serious distortions. Three areas stand out: budget expenditure is misallocated with consumption favored at the expense of investment; Indonesia is significantly under-taxed relative to its comparators, especially upper middle income countries; and Bank Indonesia has been allowed to misinterpret what an "independent" central bank is meant to accomplish. That misinterpretation has left t he economy with inflation chronically above comparable international levels and an increasingly misaligned real exchange rate. The stark truth is that not only is Indonesia's growth structurally flawed, but the country's growth rate is not high enough to double prosperity within the next decade, an aspiration held by many Indonesian leaders. According to the "Rule of 70," the most common metric for estimating how long it would take to double a country's GDP, Indonesia's real growth rate must be at least

7 percent per year to double real GDP within 10 years (70 ÷ 7 = 10). Indonesia's 5 to

6 percent growth rate of the past decade falls well short of this target, as it will take 12 to 14

years to double Indonesia's GDP at this pace. Given Indonesia's increasing population, the growth rate would have to be even higher to double GDP per capita within the next decade, an important component of shared prosperity it would have to be at least 8.5 percent per year. ix

How competitive is Indonesia's growth?

Indonesia's current positive economic performance and upbeat assessments of Indonesia's future prospects mask serious adverse trends and their long-term implications for economic growth, primarily because they confuse static with dynamic comparative advantage: Static comparative advantage reflects the economy's performance given its existing structure, accumulated technology, skills, knowledge, and government policies. Dynamic comparative advantage (also referred to as "multi-period competitiveness") takes into account modifications in productivity and competitiveness as a result of changes over time in the prices of outputs and inputs, shifts in the social opportunity costs of productive resources, and variations (positive or negative) in technology. Indonesia has a static comparative advantage in the production of raw and semi-processed agricultural and mineral products. This reflects its large cost advantage in these commodities, even after allowing for diminished profitability due to the over-valued exchange rate. The revenues from these products have supported a boom in mine and plantation investment, boosted government receipts, stimulated thriving real estate and urban services markets, increased formal sector incomes, and raised consumption expenditure. Indonesia also has static comparative disadvantages. Its contribution to international manufacturing production and distribution value chains has declined due to the high comparative costs for producers of complying with labor regulations, as well as dealing with infrastructure deficiencies, elevated borrowing costs, and diminished export returns from the over-valued rupiah Formal sector employment has expanded slowly because of labor market restrictions and the cost savings available when imported capital equipment, bolstered by exchange rate over- valuation, is substituted for labor. The economic costs of travel and transport have risen due to fuel subsidies, low taxation on vehicles, and limited public investment in transport infrastructure. Markets for goods and services across different regions are weakly integrated because of the low levels of effective demand in outer regions and inefficient inter-island transport. Utilization of formal financial services is limited because of their high real cost, poor service offered by formal credit institutions, and limited trust in the integrity and soundness of the financial system. Two good indicators of Indonesia's decreasing long-term competitiveness are changes in total factor productivity (TFP) and manufacturing value added per employee. The long-term trend in annual TFP changes is negative: from 1970 to 2007, growth in inputs has exceeded GDP growth, subtracting rather than adding value through the application of additional resources. Although the short-term trend has been positive, the changes are still too small to support the 8.5 percent GDP growth rate required to double GDP per capita in a decade: since 2000, TFP has increased by an average of 1.7 percent per year, which, if continued, would support annual GDP growth of

6 to 7 percent. The steady decline in manufacturing value added per employee since 2008,

despite the increased cost of labor and thus, the shift to the use of relatively more capital- intensive inputs, is a clear sign of falling rather than rising labor productivity. This decreases Indonesia's international competitiveness and reduces the likelihood it will move up the global value chain. x

How fairly has Indonesia grown?

Not only has Indonesia's growth performance been based on static rather than dynamic comparative advantage, but it has also been non -inclusive as inequality has risen sharply. Income inequality, measured by the Gini coefficient, has increased, and both the Java/Off-Java divide and the urban/rural gap have intensified.

With 120 million people left behind, roughly

half of Indonesia's population is not sharing the nation's growing prosperity.

Despite the positive impact

of expanded government social protection programs, they have had minimal effect on inequality. Moreover, none of them addresses the underlying causes of food insecurity, the starkest indication that exclusion persists despite robust economic growth. The implication is that if Indonesia is to be transformed by high, sustained, and inclusive growth, much more than recent rates of economic expansion supplemented by social protection programs will be needed. Conditions need to be created so that all Indonesians can substantively and continuously participate in, contribute to and benefit from economic growth. That will require the whole nation, persistently and determinedly, to raise the productivity with which it uses all of its productive factors, especially labor, as it becomes and remains more competitive. II. A Strategy for Accelerating Sustainable, Inclusive Growth:

Local and Global Integration

The Binding Constraint in Accelerating Sustainable, Inclusive Growth The binding constraint to doubling shared prosperity in a decade through the acceleration of sustainable, inclusive growth is that Indonesia exploits neither the advantages of being a large country nor its dynamic comparative advantage. Indonesia does not reap the benefits of being a large country because it is a collection of disconnected local and regional markets rather than an integrated single market - it is beset by local economic fragmentation. Indonesia fails to exploit its dynamic comparative advantage because its growth is dependent on commodities and old industries instead of high value-added products in the global supply chain - it is characterized by global economic marginalization. The key to addressing both of these problems is essentially the same, namely better hard infrastructure (ports, power, roads), soft infrastructure (government and governance), and wet infrastructure (human resources).

Local Economic Fragmentation

Indonesia has made great strides in building a unified political national identity out of an archipelago of incredible cultural, ethnic, and religious diversity. However, there is no national policy to create a single economic entity from many regional markets. At present, the sum is worth less than the parts. Indonesia does not have an integrated domestic economy. Domestic economic activity consists of a weakly connected set of loosely overlapping market domains, readily illustrated by the sharp divergence across regions in labor market conditions, financial depth, and price differentials for key staple commodities. This feature is the most prominent enduring structural deficiency in Indonesia's development activities. xi It is evident in numerous ways: shipping costs; limited inter-regional trade; price differentials and market fragmentation; barriers to transport and trade; and substantial regional differences in average earnings. Without an integrated dynamic domestic market, Indonesia has systematically missed the opportunity to benefit from having a large population. More importantly, much of the country's large population has been systematically excluded from the benefits of growth and development. The original "patterns of growth" literature distinguished countries with large populations precisely because of the advantages of scale and scope derived from their large internal market. Indonesia has failed to take advantage of its large population and generally has few inter-regional demand spillovers. This has undermined the country's capacity for income generation and employment creation. The losses have been enormous. First, lack of internal connectedness implies that a significant share of Indonesia's increasing incomes directly spills over to benefit Malaysia, Singapore, Vietnam, and China. Second, weak market integration is self-reinforcing; constraints on market size and its limited spread reduce the incentive to specialize. Third, restricted opportunities for employment expansion keep the domestic labor market fragmented and incomes low, thereby reducing the growth of inter-island commerce. Fourth, the rudimentary nature of the current division of labor in Indonesia, as well as the limited capacity to raise productivity through specialization, reinforce the existing unequal distribution of income and opportunity across the country's different regions. Fifth, the limited spread of electrification due to inadequate public investment reaffirms the perception that labor productivity is "normally" low. Sixth, macroeconomic management fragments the domestic market because the major economic institutions attempt to manage the economy as if one-size-fits-all.

Although the

lack of attention to extending the domestic market in Indonesia has been a drag on growth and development, that situation need not persist. Extending and integrating the domestic market - systematically, coherently and sustainably - provides Indonesia with the prospects of rapid inclusive growth for decades to come. Doing this requires: the creation of spatially-blind institutions that avoid regional or location biases; the promotion of spatially-networked investments to integrate more closely regions and districts; and the formulation of spatially-targeted interventions that encourage social andquotesdbs_dbs43.pdfusesText_43

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